Diversify Further! Checkbook Investing With IRA Funds
- Becoming able to directly invest your IRA funds opens up many investment opportunities.
- To do this, you establish an LLC, but in a rather convoluted way.
- Here I take you through the process I used, and you could use, to take advantage of the wider diversification this makes possible.
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I decided recently to begin making direct investments using retirement funds. Figure 1 shows some of the opportunities. One may find private equity investments. One may decide to invest in gold, cryptocurrencies, or commodities. One may decide to invest in real estate or real estate loans.
Figure 1. Many investment options open up with a self-directed IRA. Source.
A promising approach to many such investments is to make them via crowdfunding sites (Figure 2). Examples in real estate include EquityMultiple and Fundrise. A more off the wall example is to crowdfund a mine.
This article reports my experiences getting to the point of being able to invest and beginning to do so.
Figure 2. Crowdfunding can provide an effective path to diversification. Source.
The Tax Man Has Many Colors
For a number of years, I will be paying a good bit of regular income taxes as I pull funds progressively out of the TIRA environment and into Roth funds or taxable funds. Deciding how to go about this is an interesting issue.
Because my funds have been locked away, I have worried little about taxes on investment income. For any funds that are not held long enough for the earnings on the earnings to become significant, at first blush it does not matter where one puts them.
So I started accumulating some after-tax funds and began to invest them. I was happily proceeding until out of the blue I remembered … NIIT.
NIIT is the Net Investment Income Tax. As one of the compromises associated with the 2017 tax bill, this tax was made more onerous. If you exceed an income threshold, as I will at least until I finish pulling funds out of the TIRAs, then you pay an extra 3.8% on investments that might be described as passive. Ouch! The implication for me is that I need to be doing my direct investing from within an IRA.
This is not the end of the tax story, though. I also recalled that congress did not kill the Alternative Minimum Tax (ATM). They made it less onerous for most relatively high earners, but it is still there. This led me to consult my tax attorney. He found that, because I now have relatively little taxable investment income, this is not an issue for me personally at present.
A Roth Alone is Not Enough
My next thought was to pay some of those taxes to move funds from the TIRA into a Roth IRA. I don’t want to continue being buried in TIRA issues.
In that previous article, I considered Roth IRAs rather superficially. This led to an enormous number of comments about the Roth rules. What I found remarkable is that different people read the IRS documents and come to firmly held and contradictory conclusions.
Under the recent tax law, one can now convert any amount of TIRA funds to Roth funds by doing a “Roth Conversion”. One can do this at any time. One owes regular income taxes on the TIRA funds when one makes the conversion.
So I can convert any amount of TIRA funds to Roth funds, so long as I can tolerate the taxes. There is a lot of outdated and wrong information about this out there.
Withdrawals from the Roth account are more complex. I believe the H&R Block website has this right, and also expresses things unambiguously. The relevant parts are here:
Roth IRA Withdrawal Rules
Because your Roth IRA contributions are made with after-tax dollars, you can withdraw your regular contributions (not the earnings) at any time and at any age with no penalty or tax. After you withdraw an amount equal to all of your regular contributions, the earnings will be taxable only if the distribution isn’t a qualified distribution. If the distribution is qualified, then none of your distribution will be taxed.
All of your Roth IRAs are treated as one for the purposes of withdrawal rules. It doesn’t matter how many Roth IRA accounts you have.
Distribution Ordering Rules for Roth IRAs
If the money you withdraw from a Roth IRA isn’t a qualified distribution, part of it might be taxable. Your money comes out of a Roth IRA in this order:
- Regular contributions — always tax- and penalty-free
- Conversion contributions — which come out on a first-in, first-out basis. So conversions from the earliest year come out first.
- Earnings on contributions
Roth IRA Earnings & Withdrawal Rules
Your earnings are tax-free if both of these are true:
- You’ve had the Roth IRA for at least five years.
- You’re age 59 1/2 or older when you withdraw the money.
Not mentioned is that each Roth conversion starts its own 5-year clock for withdrawing earnings. This will be a non-issue if you put enough into the Roth the first year that you don’t withdraw all the contributions within five years.
Most major brokerages support Roth conversions. A lot of my funds are with Fidelity, and it is straightforward with them to do the conversion.
However, poking around on their website gave no clue how to use the Roth funds for the investments I want to make. Just having a Roth is not enough.
The Answer: Checkbook Control!
What one needs in order to fully control direct investments is what is checkwriting functionality, also known as checkbook control. One needs the equivalent of a checking account, from which one can direct funds wherever one wishes.
The two paths to doing this are each a bit complex. Both are legal and feasible for any type of IRA (TIRA or Roth). You should get help from, and pay, one of the organizations that specializes in this area if you pursue it.
Figure 3. Flow chart showing the structure of an “IRA LLC”. By author.
In the path I favor, illustrated by the flowchart in Figure 3, you create an IRA with an IRA Custodian and roll funds into it. You simultaneously pay someone to set up a limited liability corporation (LLC) whose name you choose. The Custodian invests in (buys shares in) the LLC using the IRA funds, making the IRA the owner of the LLC.
You appoint yourself as the manager of the LLC and direct the disposition of the funds. You do this using an ordinary commercial bank account. This convoluted structure has been tested in court and is now approved by the IRS.
The other path is to establish an SDIRA Trust in which the IRA is both the grantor and the beneficiary of the Trust, and you are the Trustee. (This is NOT what is sometimes called an “IRA Trust,” which is quite different.) The SDIRA Trust must be accepted by a holding Custodian. As Trustee, you deploy the funds within the trust.
There are quite a few companies that specialize in one or both of these structures. Examples include IRA financial group, RocketDollar, Broad Financial, American IRA, and Horizon Trust.
Establishing the LLC and Custodial Accounts
The process of establishing a Checkbook LLC account is structurally as follows, and is illustrated in Figure 4. You connect with a company (a servicer) who specializes in setting up Checkbook LLC IRAs. They are ready to establish a Limited Liability Corporation (LLC) with the correct legal structure to be used with an IRA to provide checkbook control. You will pay this first company a fixed, one-time fee to set things up.
That company takes an application from you and somehow connects you with the separate (but likely co-owned) trust company that is a registered IRA Custodian. Your ongoing interactions will be with the trust company, for which you will pay a regular fee. You will also have to use their processes for dealing with funds.
My Experience Getting Started
What I found deeply annoying was that the websites of the companies I checked out were all sales-oriented and superficial. None of them provided a clear explanation of the details; none of them disclosed fees or related requirements fully; and none of them provided clear information about the trust company.
I first tried working with Broad Financial. They were very helpful on the front end but took my money before even informing me how to see relevant documents about the trust company. When I proceeded to my due diligence, I was so disappointed by multiple aspects of the trust company documents that I backed out of the entire transaction. Broad Financial was prompt and efficient in refunding my money.
I then turned to IRA Financial. Having been burned once, I snooped around to identify the trust company (IRA Financial Trust), found their “forms” webpage, and reviewed all the relevant forms before proceeding.
Overall, the application process with IRA Financial was not too painful. Even better, they did signatures via DocuSign and in the process presented all the relevant documentation including information about fees and minimum account balance requirements.
It appears that IRA Financial and their trust company are trying hard to improve the consumer experience.
The ongoing fees will add up to a few hundred dollars per year. If you are not moving enough money to make it sensible to be paying this much, then this path is not the right one for you.
The Next Steps and Pauses
I submitted the form July 11. There were a couple of interactions by phone with the individual taking care of the details. Then I saw the wire transfer go through to move the initial funds. A day later, on July 17, I got an email enabling me to establish online access for the account with IRA Financial Trust.
Figure 4. The process of establishing and LLC IRA, giving you checkbook control. By author.
At this point what I had was another Roth IRA, from which I could make any investments I cared to by working through the Custodian (IRA Financial Trust).
A week later I was still waiting for the LLC and for the checkbook control. I inquired and learned that my servicing agent was waiting for approval of the LLC by my state — slow wheels of government.
Eventually, on August 5, I was contacted and asked whether I wanted IRA Financial to set up the bank account, using their connection with Capital One Bank, or to set up my own. As I have extensive relationships with my own bank, where I get individual and immediate service, I went that route.
For the bank I needed the Operating Agreement for the LLC and also the EIN assignment letter. (The EIN for an organization is like an SSN for an individual.) I got these two documents and the Articles of Organization by email.
Almost there! Moving the money
The IRA Financial representative also sent me the set of (5) forms needed to establish the checkbook LLC agreement with the Custodian. A lot of this involves repeatedly acknowledging that I understand what am not allowed to do with the LLC funds. (These are things like paying myself directly.)
My bank got the account set up within a day, and I returned the 5 forms to IRA financial. They included a wire transfer request and more affirmations that I would be a good boy.
Within a couple more days, on August 9, the funds were transferred and I was able to begin investing. I started with a small amount of funds. I will, in due course, move more funds as I take this portion of my portfolio to the level I desire.
Still More Paperwork
One aspect of IRAs is that the Custodian must certify the value of their assets to the IRS every year. You don’t see this for your ordinary TIRA or Roth accounts, but it does happen.
But you have to be in the loop if you have checkbook control. IRA financial is willing to let you certify the value without other confirmation with the exception below.
Another Custodian I found at random wanted the yearly evaluation independently certified every year. This could be a significant cost if you use the funds to invest directly in real estate, because you may have to get a formal appraisal each year. And it still would be an expensive pain for any investment.
The exception for IRA Financial arises when you take a taxable distribution or do a Roth conversion. In that case, you do need to find an independent certifier.
Some advance thinking and preparation is also needed in this connection. IRA Financial wants the form by January 15.
Comments on this aspect from any readers with experience would be valued
The Bottom Line So Far
Is this worth doing for you? Here is how I would look at it.
I don’t mind tying up a percent or so of capital in minimum balances and such. And I would not want the associated fees to exceed a percent, though I’d prefer them to be lower.
To meet these requirements, there would be no point in going this route unless one had a minimum of $50k to use for such investments. By the time one is investing $100k or more this way, the associated costs become quite tolerable.
As I have written about, I am a big believer in diversification into uncorrelated areas. This gets a lot easier outside the usual markets accessed by the big investment houses.
Going forward, I expect to sustain this kind of investing as part of my portfolio. It is, almost literally, “out of the box”.
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This article was written by
Paul brings substantial experience in research, and in understanding and developing models of uncertain systems, from his decades working as a physicist. He wrote his first Monte Carlo model aimed at investments in 2006. He has intensively researched and modeled a wide variety of portfolio options. Among other degrees, he holds a doctorate in physics and a bachelors in philosophy. His career began with running large projects for a major research laboratory, and continued with a long, and award-winning run as a professor at the University of Michigan. He has authored nearly 300 articles published in formal academic journals, and two editions of a textbook.
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